Chapter 6 - Dynamics of Financial Crises in Advanced Economies

Chapter 6 – Dynamics of Financial Crises in
Advanced Economies and Applications

Financial Crisis in Emerging Economies- Fall 2023
LAU Beirut
1
1-Dynamics of Financial Crises in Advanced Economies
Dynamics of financial crises in advanced economies or the sequence of events can be

explained in 3 stages.
Stage One: Initiation of Financial Crisis
Stage two: Banking Crisis
Stage three: Debt Deflation
2
Stage One: Initiation of Financial Crisis (defined as sharp drop in economic activity)
3 to 4 factors can disrupt the information flows in financial markets and increase
asymmetric information problems i.e. aggravate the adverse selection and moral hazard
problems and thus cause a considerable decline in economic activity (financial crisis).
This is because when financial frictions increase sharply, lenders become unable to
assess properly the financial position and creditworthiness of borrowers and thus banks
will be inclined to reduce or stop credit extension and financial markets stop functioning
efficiently. The end result deteriorating economic activity
Adverse selection problems-when potential bad credit risk borrowers are the ones who
most actively seek out a loan- and moral hazard problems: when borrowers have
incentives to invest in high risk projects- So what are these 3 to 4 factors?
3
 1- Mismanagement of financial liberalization/innovation
Financial liberalization and innovation involve the elimination of earlier or existing

restrictions and introduction of new types of loans or other financial products.
Financial liberalization and innovation can lead to a credit boom often involving risky
lending, if the process is not well sequenced and there is no proper risk management in
place.
There are many issues that can weaken incentives for proper risk management including
the limited number of creditworthy projects, the limited capacity to assess and monitor
projects at banks, and not properly designed government safety nets (lender of last resort
facility and deposit guarantee scheme) allowing bank management to take excessive risk
and depositors to ignore bank risk-taking.
4
Eventually, when the credit boom and asset price bubble come to an end, loan losses
accrue at banks, and their asset values fall, leading to a reduction in their capital.
Lower net worth means lower ability to absorb losses and to extend credit. Financial
institutions cut back in lending, a process called deleveraging.
Banking funding falls as well. With less capital, financial institutions become riskier
(higher capital risk and risk of insolvency), causing potential lenders to these
institutions (depositors and other creditors) to pull out their funds.
As FIs cut back on lending, a few are left to evaluate firms (Loss of information
production and disintermediation). Economic spending narrows as loans become scarce.
5
 2- Asset price boom and bust
A pricing bubble starts, where asset values (equity shares and real estate) exceed their
fundamental prices.
When the bubble bursts and prices fall, corporate net worth and the value of the collateral
they can pledge falls as well.
Moral hazard increases as firms can make risky investment and have little to lose.
FIs tighten lending standards and contracts and also in response to the fall in their assets
and net worth, deleverage and cause a decline in economic activity.
6
 3- Spikes in interest rates
Many 19th century crises initiated with a spike in rates, due to a liquidity problems or
panics. Moral hazard also increases with rising interest rates as loan repayment becomes
more uncertain, reducing lending and economic activity.
 4- Increase in uncertainty
Caused by failures of major financial institutions, stock market crashes or start of a

recession.
Periods of high uncertainty slow the information flow, increase financial frictions and
reduce lending and economic activity.
7
Stage two: Banking Crisis
The decline in economic activity in stage one leads to a banking crisis, which can worsen in
turn adverse selection and moral hazard problems and diminish further economic activity.
Deteriorating balance sheets can lead some financial institutions into insolvency with
negative net worth. If severe enough, these insolvencies can lead to a bank panic.
Panics occur when depositors are unsure which banks are insolvent, causing all depositors
to withdraw all funds immediately.
As cash balances fall, FIs must sell assets quickly (fire sale of assets), further deteriorating
their balance sheet →insolvency, failures and panic
With fewer banks operating, adverse selection and moral hazard become severe – lower
lending and economic activity.
8
Stage three: Debt Deflation occurs as deteriorating economic activity causes a decline in the
price level, and where asset prices fall, but debt levels do not adjust, increasing debt burdens.
• Sharp or substantial unanticipated decline in the price level

• Increased firms’ indebtedness due to the increase in the real value of firms’ debt (liabilities)
• Decline in real net worth (A-L) of borrowers (firms)
• Increase in adverse selection and moral hazard problems facing banks (lenders)
• Lending activity declines
• Economic activity declines
9
Sequence of Events in
Financial Crises in
Advanced Economies
10
2-Application: The Mother of All Financial Crises: The Great Depression
-Started in the mid 1929 and the economy hit bottom in 1933 .
-Income in the U.S was cut in half and economic output fell by a third.
-Unemployment rate reached 25 percent due to the prolonged economic contraction.
The depression was a catastrophe and the worst financial crisis ever in the U.S. This long
and deep recession led also to a severe global economic depression due, among other
things, to the US establishing a protectionism tariff regime, implying import restrictions
affecting countries heavily dependent upon exports .
Repercussions spread via international trade and finance to other countries, which
experienced in turn lower output and higher unemployment in addition to poverty and
misery. The effects in some countries spanned the period from 1929 till late 1930s and
sometimes early 1940s. 11
-It began on October 24, 1929 , “Black Thursday,” when the New York Stock market
fell 9 percent.
-Followed by “Black Monday”, October 28, 1929, when the stock market fell by a
further 13 percent.
-Succeeded by “Black Tuesday”, October 29, 1929, when the market lost another 12
percent.
After many downs and ups, the market ended in 1933 at about 1/6 of its 1929 level.
The market reached its lowest point in July 1932 where the Dow Jones hit 41 from a
high of 381 in 1929. A decline of around 90%.
12
-The stock market crash ended or deflated an unsustainable speculative bubble and
created uncertainty.
It hit the willingness of investors and consumers to invest and spend and
encouraged the desire to save financial or cash resources for unexpected events or
emergencies.
-In fact the stock market experienced massive gains in the pre-crisis period specifically
from 1926 to 1928. Market indices moved up about 400 percent.
-Relaxed credit terms from banks and brokers fuelled this buying fever and business
activity reached its peak two months before the stock market collapse.
13
In the years preceding the great depression (from 1921-1929):
 Real incomes, money supply and industrial production rose steadily.
 Fed set relatively low interest rates and low reserve asset requirements allowing credit
expansion.
 Buying on margins was common (i.e. clients pay or put down only 10% of the amount of
stock market purchase and pay later the remaining 90% borrowed from a broker or
bank).
 Investment trusts were active (companies that invest in stock market listed firms and
their assets are financed by 70 % borrowing from a bank and 30% raised from
shareholders).
14
-It is argued that in response to the doubling of stock prices in the U.S in 1928 and 1929,
the Fed tried to curb this period of excessive speculation with a tight monetary policy. But
this lead ultimately to the stock market crash and a collapse of stock prices in October of
1929.
-Very high volumes of trading played also a role in causing the crash by putting pressure
on the timely flow of information and on the system for tracking the market prices,
reducing thus market confidence and contributing to panic selling.
-Shock to the system with industrial production going into reverse is also considered one
of the crash culprits.
15
In the upswing as the bubble forms, we have steady rise in prices supported by substantial
borrowings used to reinforce buying.
As the bubble bursts or deflates, prices drop and there are either margin calls by banks and
brokers or the value of collateral becomes insufficient to cover bank loans.
Either way and to meet lenders’ requirements, investors and borrowers become forced
sellers of assets (have to sell shares) and this further depresses the market, justifying why
do asset values fall so rapidly after the burst of a bubble.
When markets go into reverse, not only the shares of investors, who bought on margins,
and investment trusts could become worthless but also such investors still need to repay
the bank and brokers for borrowed funds.
16
Likely outcomes:
-Many investors start to go bankrupt.
-Banks may suffer from bad debts and shortage of liquidity.
-Banks become cautious about making new loans as they have already much trouble with
bad debts on existing loans, and may lack capital (as bad debts multiply) to make new
loans.
-Banks can fail when the level of bad debts wipe out their capital and so depositors lose
money.
-Both demand for and supply of new loans subside.

17
Bank panics: Further, to the bank failures in the wake of the wall street crash, between
1930 and 1933, one-third of U.S. banks went out of business as agricultural shocks led to
more bank closures.
Adverse selection and moral hazard in credit markets became severe. Firms with
productive uses of funds were unable to get financing. Credit spreads increased from 2%
to nearly 8% during the height of the Depression.
Debt deflation: The deflation during the period was substantial with a 25% decline in
price levels. Debt deflation caused those who borrowed earlier to owe even more in real
terms to lenders.
Add to this that wages were not getting paid, people were being laid off, cash was drying
up, and banks ceased lending and were writing off bad debts.
18
Stock Price Data During the Great Depression Period
Source: Dow-Jones Industrial Average (DJIA). Global Financial Data;

www.globalfinancialdata.com/index_tabs.php?action=detailedinfo&id=1165.
19
Credit Spreads During the Great Depression
Source: Federal Reserve Bank of St. Louis FRED database;

http://research.stlouisfed.org/fred2/categories/22.
20
2- Application: The Mother of All Financial Crises: The Great Depression
• It has been argued that neither the monetary policy nor the fiscal policy helped in
increasing aggregate demand, which fell due to a reduction in consumption and
investment spending with the large scale loss of confidence, and remained at low
levels for long periods.
• Thus adverse economic effects may have been alleviated had the central bank
expanded the money supply by more than the usual amount to offset the contraction
and the government increased spending or reduced taxes.
• In fact many monetarists believe that the great depression started as an ordinary
recession and what made it a massive depression were policy mistakes by the Fed
that resulted in shrinking the money supply and therefore exacerbating the economic
contraction.
21
2- Application: The Mother of All Financial Crises: The Great Depression
• Some would argue that the Fed did not act sufficiently at that time because the
amount of credit it could issue was limited by laws which required partial gold
backing of that credit under the gold standard (the international monetary system).
• Responses to the great depression came late (during 1933-1936) with a series of
economic programmes focusing on the relief for the unemployed and poor, recovery
for the economy to normal levels, and reform of the financial system to prevent a
repeat of the depression.
• There have been also the devaluation of the dollar against gold from USD 20.67 per
ounce to USD 35 per ounce (where it stayed for 35 years) and the enactment of The
Emergency Banking Act .
• Yet Real GDP did not regain its pre-depression level until 1937. Unemployment
stayed above 15 percent until 1939. 22
3- Application: The Global Financial Crisis of 2007-2009
Causes:
1- Financial innovations emerge in the mortgage markets
Subprime and Alt-A mortgages

Mortgage-backed securities
Collateralized debt obligations (CDOs)
Less-than-creditworthy borrowers found the ability to purchase homes through subprime

lending, a practice almost nonexistent until the 2000s.
Commercial banks and mortgage lenders have responded positively to government’s

desire to lend more to weak credit customers given that the bank will not hold these
subprime loans on its own books /balance sheet but will sell them on.
23
• In fact, the US government started in the mid 1990s and onwards to praise the virtues
of widening home- ownership and encourage people to own houses and they have set
up for this reason various agencies to facilitate this issue.
• Fannie Mae and Freddie Mac bought mortgage loans from originators and bundled
them into large pools and issued securities backed by the proceeds (principal and
interest) on mortgage loans (Mortgage backed securities MBS) .
• At first, Fannie Mae and Freddie Mac securitized conforming mortgages, which were
lower risk and properly documented. Maximum Loan amount/ housing value 80%.
24
•Later, Fannie Mae and Freddie Mac and other private firms began securitizing
nonconforming “subprime” loans with higher default risk and low documentation.
• Little due diligence as long as loans could be sold to investor. Little verification of
ability to carry a loan and the ratio of loan amount/housing value much exceeded
80%
• Placed higher default risk on investors (no guarantee by government agencies).
• Fannie and Freddie were allowed and even encouraged to buy subprime mortgage
pools to make housing more affordable to low income households. These loans turned
out to be disastrous with massive losses spread among banks, hedge funds, investors,
and Freddie and Fannie. In September, 2008, Fannie and Freddie got taken over by the
federal government.
25
• Financial engineering developed new financial products to further enhance and

distribute risk from mortgage lending.
• There has been therefore a change in the nature of bank lending involving a shift from
the traditional model of ‘originate to hold’ to a new model of ‘originate to distribute.’
• Under the classical ‘originate to hold’ model , the commercial or mortgage bank
would extend a loan against the collateral of a home and the bank would maintain the
loan on its books and receive interest and principal repayments.
26
• Under the new ‘originate to distribute’ model the commercial or mortgage bank also
grants a loan against the collateral or security of a home but will not maintain the
loan/debt but instead will sell it to another banking institution or to a special vehicle.
• The SPV will buy a volume of alike loans from different commercial and mortgage
banks and pack them together to sell later on to investors as mortgage back securities
(MBS) through the securitization process.
• Otherwise, the SPV may mix up housing loans with different types of other
loans/debts such as car loans, credit card loans, corporate loans and the bundle is sold
on again to investors as CDOs (Collateralized Debt Obligations).
27
The creation of a collateralized debt obligation (CDO) involves a corporate entity

called a special purpose vehicle (SPV) that buys a collection of assets such as
corporate bonds and loans, commercial real estate bonds, and mortgage-backed
securities.
The SPV separates the payment streams (cash flows) from these assets into buckets
that are referred to as tranches.
The highest rated tranches, referred to as super senior tranches are the ones that are
paid off first and so have the least risk.
The lowest tranche of the CDO is the equity tranche and this is the first set of cash
flows that are not paid out if the underlying assets go into default and stop making
payments. This tranche has the highest risk and is often not traded.
28
3-Application: The Global Financial Crisis of 2007-2009
2- Housing price bubble forms
• Few years before the crisis real interest rates were extremely low (real interest
rates negative or close to zero) not only in the US but globally due to international
coordination).
• Low interest rates fueled consumption spending on domestic and foreign goods of
which Chinese exports and china in turn recirculated exports related inflows by
purchasing US government bonds and thus financing US deficits.
• Increase in liquidity from cash flows surging to the United States and public
spending growing rapidly.
• Booming economy and happy consumers: spending, borrowing cheap money, and
buying properties that they could not afford before. 29
• This environment fueled economic boom and a bubble in house prices not only in
the US but also in the UK and other countries.
• Development of subprime mortgage market fueled also housing demand and

housing prices.
• This resulted in increase household indebtedness as a percentage of disposable

income.
• Banks took advantage of low interest rates and increased their debt levels as a
share of total financing (debt/equity from 10 to 25 and even more). Implying
excessive risk taking as a small drop in assets value could wipe up total capital.
30
3- Agency problems in mortgage markets arise
• “Originate to distribute” model is subject to principal (investor) agent (mortgage

broker) problem.
• Borrowers had little incentive to disclose information about their ability to pay.
• Commercial and investment banks (as well as rating agencies) had weak
incentives to assess the quality of securities.
• Agency problems in mortgage markets reached new levels:
-Mortgage originators did not hold the actual mortgage, but sold the note in the
secondary market.
-Mortgage originators earned fees from the volume of the loans produced, not the
quality.
In the extreme, unqualified borrowers bought houses they could not afford.
31
Originate to Hold vs Originate to Distribute
Traditional ‘Originate to Hold’ Model New ‘Originate to Distribute’ Model

• Banks careful about the ability of customers to • Low level of care when screening and accepting
repay their long term housing loans and will carry loan applications.
out diligent screening and appraisal.
• Credit analysis standards and procedures
• Credit analysis standards and procedures abandoned.
respected.
• Dishonest deals and scams where mortgage
brokers and dealers, borrowers and lawyers
collude to receive monies from lenders in excess of
market value and abuse the deal.
• One of the tricks borrowers indicating that they
would occupy the purchased property while in
reality purchasing its as a investment to let or to
trade. Other tricks, fictitious purchaser and others.
Originate to Hold vs Originate to Distribute
Traditional ‘Originate to Hold’ Model New ‘Originate to Distribute’ Model

• Mortgage lending criteria : 3x the borrower’s • Mortgage brokers aiding borrowers to falsify their
income or 80-90% of the value of the property employment history and income and hide critical
mortgaged. information.
• Some lenders accepting self certified (by the
borrower) income figures.
• Stretched lending criteria with some lenders
offering loans of 100 percent and plus on homes.
4- Information problems surface

The role of asymmetric information in the credit rating process. the rating agencies
didn’t help:
Agencies consulted with firms on structuring products to achieve the highest rating,
creating a clear conflict.
Further, the rating system was hardly designed to address the complex nature of the
structured debt designs.
The result was meaningless ratings that investors had relied on to assess the quality of
their investments.
34
5- Credit Default Swap (CDS)
Credit default swaps available on loans, bonds, mortgage backed securities and
collateralized debt obligations.
The credit default swaps are credit derivative contracts between two parties. They
protect the protection buyer from non-payment of interest or failure to make a
principal/capital repayment by a company on a loan or bond issued. The protection seller
provides such protection.
CDS have a specified contract life and involve rights and obligations (no options). One
party makes a series of payments to the counterparty in exchange of one time payment
by the counterparty if the credit instrument (bond/loan) which the CDS relates defaults.
35
CDS are thus instruments that provide insurance against the risk of default by a
particular company or government and are therefore very much like insurance but there
are major differences:
-Neither party (the buyer and the seller) to a CDS needs to own the underlying security
(bond, loan…) to which the CDS relates.
-There is a secondary market in which CDS can be traded.
-With a CDS one can hedge risk or gamble and speculate.
-Neither the buyer nor the seller of the CDS has to suffer a loss from the default event
if the CDS is not held by them.
36
-There is no legal limit to the number of credit default swaps (value of CDS
outstanding on debt) that can be entered into in respect of a particular risk (the actual
debt value).
The subprime mortgage market had debt outstanding of USD 1.3 trillion at
its peak whereas the CDS market had USD 60 trillion outstanding at its peak.
Note that CDS contracts were less than USD 1 trillion in 2001 and increased
exponentially to over USD 60 trillion in 2007, before the crisis.
This is to stay that the contribution of the subprime debt defaults to the blow up in
the financial markets has been minor in respect of the contribution of the collapse in
the CDS market. 37
When no default or low probability of default : Positive CDS value

When default or high probability of default: Low to negative CDS value
Meaning what was considered an asset with a positive value under business as usual may
become a liability with a negative value in distress times as the chances of paying out to
the insured (protection purchaser) increase.
Another role CDS played in the crisis is that they allowed the transformation of MBS and
CDO securities from junk or low grade debt status (in line with what subprime
mortgages are) to triple A or highest grade debt status.
How? By banks packaging CDS with subprime loans and other loans into CDOs and
tranching such securities where in cases CDOs produce losses, the first loss fall on the
lowest tranche (could be rated B), the next loss falls on the next lowest tranche (could be
rated BB),… until the last tranche to suffer the loss (rated AAA). 38
Initially investment banks packaged subprime debt into mortgage backed securities and
made big profits and bonuses.
Then they added to this mortgage pool other type of assets (credit card debt, corporate
debt, private equity debt…) thought uncorrelated and packaged with them CDS to
enhance asset quality and credit rating in creating collateralized debt obligations (CDOs),
creating greater profit and bonus potential.
CDOs issuers and arrangers were also able to convince rating agencies to rate many CDO
tranches AAA though the underlying assets carried much lower ratings simply because of
the use of credit default swaps in creating CDOs and the splitting of these into tranches
based on the seniority of claims.
39
5- Housing price bubble bursts
By 2007, the US Federal Reserve Funds rate reached 5 percent from 1 percent in
2005.
The housing market changed direction, mortgage interest and principal repayments
were not upcoming, and foreclosures on properties started to emerge.
This meant also that the income of the MBS and CDO and other instruments backed
by the proceeds on housing debt was adversely affected.
Market prices started to fall, market liquidity dried up when interbank market
stalled, subprime mortgage business collapsed, and foreclosures accelerated.
40
Effects:
1- US Residential Housing: Falling housing prices
Initially, the housing boom was praised by economics and politicians. The housing
boom helped stimulate growth in the subprime market as well.
However, underwriting standard fell. People were clearly buying houses they could not
afford, except for the ability to sell the house for a higher price.
Lending standards also allowed for near 100% financing, so owners had little to lose by
defaulting when the housing bubble burst.
41
Housing Prices: 2002–2010
42
Some economists have argued that the low rate interest policies of the Federal Reserve
in the 2003–2006 period fueled the housing price bubble
Taylor argues that the low federal funds rate led to low mortgage rates that stimulated
housing demand and encouraged the issuance of subprime mortgages, both of which led
to rising housing prices and a bubble
In early 2009, Mr. Bernanke rebutted this argument. He argued rates were appropriate.
He also pointed to new mortgage products, relaxed lending standards, and capital
inflows as more likely causes.
The debate over whether monetary policy was to blame for the housing price bubble
continues to this day.
43
2- Banks’ balance sheets

As mortgage defaults rose, banks and other FIs saw the value of their assets falls. This was
further complicated by the complexity of mortgages, CDOs, defaults swaps, and other
difficult-to-value assets.
Banks began the deleveraging process, selling assets and restricting credit, further
depressing the struggling economy.
3- Shadow banking
The shadow banking system also experienced a run. These are the hedge funds, investment
banks, and other liquidity providers in the financial system.
When the short-term debt markets seized, so did the availability of credit to this system.
This lead to further “fire” sales of assets to meet higher credit standards.
44
4- Global Financial Markets
Crisis spreads globally

Sign of the globalization of financial markets
TED spread (3 months interest rate on Eurodollar minus 3 months Treasury bills
interest rate) increased from 40 basis points to almost 240 in August 2007.
The fall in the stock market and the rise in credit spreads further weakened both firm
and household balance sheets.
Both consumption and real investment fell, causing a sharp contraction in the economy.
45
Stock Prices: 2002–2010
46
Credit Spreads: 2002–2010
47
5- Failure of Banking Firms
High-profile firms fail
Bear Stearns (March 2008)

Fannie Mae and Freddie Mac (July 2008)
Lehman Brothers, Merrill Lynch, AIG, Reserve Primary Fund (mutual fund) and
Washington Mutual (September 2008).
March 2008: Bear Sterns fails and is sold to JP Morgan for 5% of its value. Before its
collapse, the bank’s CDS spread increased drastically. A large number of buyers were
taking out protection against the bank’s failure. This widening in the spread increased
further the bank’s vulnerability and reduced its access to wholesale money markets
leading eventually to its collapse.
48
September 2008: both Freddie and Fannie put into conservatorship after surging
subprime losses.
September 2008: Lehman Brothers files for bankruptcy. Same kind of scenario that
impacted Bear Sterns
September 2008: American International Group (AIG) also experiences a liquidity

crisis. It required a government bailout as it had been selling huge amounts of CDS
protection (without hedging) against the possibility that different companies/reference
entities might decline in value or default.
Merrill Lynch sold to Bank of America at “fire” sale prices.
49
The end of credit lead to several bank failures.
Northern Rock was one of the first, relying on short–term credit markets for funding.
Others soon followed.
By most standards, Europe experienced a more severe downturn than the U.S.
The collapse of several high-profile U.S. investment firms only further deteriorated
confidence in the U.S.
50
6- The Economy
The crisis and impaired credit markets have caused the worst economic contraction
since World War II. The fall in real GDP and increase in unemployment to over 10% in
2009 impacted almost everyone.
Bailout package debated

House of Representatives voted down the $700 billion bailout package on September
29, 2008. It passed on October 3.
Congress approved a $787 billion economic stimulus plan on February 13, 2009.
51
4- The Great Depression of 1929 vs. The Global Financial Crisis of 2007-9
Similarities Dissimilarities
• Expansion of credit • Widespread bank failures, tight money supply,
deflation, widespread unemployment, and
• Resilient economic growth and rise in real
protectionism (Great Depression) vs.
incomes.
• Banks were propped up, money injected into the
• Boom in stocks (Great depression of 1929) and in
system to overcome the credit crunch, and efforts
housing prices (Financial crisis of 2007-9).
taken to avoid deflation, protectionism and high
• Use/emergence of risky debt products (geared unemployment.
investment trusts and trading on very generous
margin terms in 1929; toxic assets or debt written
by banks in 2007-9).
• Shock to the system (reversal in industrial
production in 1929 leading to an exit from the
stock market and reversal in housing in 2007-9).
52
Appendix: Credit Default Swaps (CDS)
Payment if credit default event occurs
Bank X: CDS seller Investor Y: CDS buyer

(protection seller) (protection buyer)
Premiums paid periodically
Has the obligation to buy Has the right to sell the debt
the debt (bonds, loans) (bonds, loans) issued by a
issued by a particular particular company or
company or government Z government Z for their face
(reference entity) for their value when there is default
face value when a credit by the company or
event occurs government 53
One time payment to the

CDS buyer if credit default
occurs, and the settlement
involves either physical
delivery of the bonds/loans
or a cash payment
Payment if credit default event occurs
Bank X: CDS seller Investor Y: CDS buyer

(protection seller) (protection buyer)
Premiums paid periodically
Credit default swap

premiums are periodic
payments (quarterly, semi
annually or annually) to the
seller until the end of the life
of the CDS (i.e. 5 years) or
until a credit event occurs 54
The spread on a CDS is the annual amount that the protection buyer (investor Y)
must pay the protection seller (X) over the life of the contract and it is stated as a
percentage of the nominal amount of the CDS contract.
The nominal amount of the CDS contract is the amount of protection. So if an

investor Y is buying USD 10 million worth of protection and the CDS spread for
company Z is 100 basis points (1 percent) then the investor must pay the protection
seller X the amount of USD 100,000 per year until the CDS contract expires (for
example over 5 years) or until company Z defaults.
The cost of credit default swap goes up when the probability of default increases.
55
Both the buyer and the seller:
-May not or usually do not own

underlying debt (bonds/loans)
-Need not to be regulated. No

Bank X: CDS seller clearing house for CDS transactions Investor Y: CDS buyer
(protection seller) but done over the counter (OTC) (protection buyer)
-Can sell their CDS positions on the

secondary market
-Will not suffer a loss from the

default event if the CDS are not held
by them
56
• The value of the CDS brought falls in value when the company/government Z
suffers a credit rating downgrade due to certain developments. This is because of
the rising possibility of default and the need to make payments when default
occurs.
• CDS would be a hedge against risk if investors own actually debt in company Z.
• CDS would be speculative transactions if investors buy CDS contracts without
owning any company Z debt.
57
Case of speculation:
-Hedge fund (H) feels that Company (C) will sooner or later default on its debt.
-Hedge fund (H) buys USD 10 million worth of CDS protection for five years from
an investment bank (I) with company (C ) as the underlying reference entity at a
spread of 500 basis points per annum.
-If company C does actually default after 3 years, then the hedge fund would have
paid USD 1.5 million (0.05 x 10 x 3) to the investment bank (I) but would receive in
return USD 10 million.
-The profits made by the Hedge fund USD 8.5 million (10 – 1.5) are the losses
incurred by the Investment bank
58
-Note that the investment bank might not incur losses if it hedges its position by
entering into a reverse purchase deal to eliminate its exposure.
-Note also that he hedge fund could not have benefitted and made profits but instead
losses had the company C not defaulted and the hedge fund made payments over the
entire life of the contract (USD 2.5 million without any return).
-The hedge fund might opt alternatively to sell on the CDS in the secondary market
much before the expiry of the contract (after 2 years for example). The hedge fund
will then make a profit on the sale if the likelihood of default when making the sale
is higher than when the fund bought the CDS.
59
-The amount of profit will depend on the new price of the CDS contract, which
hinges in turn on the increased risk of company C’s default.
60

Chapter 6 - Dynamics of Financial Crises in Advanced Economies

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Chapter 6 - Dynamics of Financial Crises in Advanced Economies

Uploaded by

Copyright:

Available Formats

Chapter 6 – Dynamics of Financial Crises in

Advanced Economies and Applications

Dynamics of financial crises in advanced economies or the sequence of events can be

Stage One: Initiation of Financial Crisis

Stage two: Banking Crisis

Stage three: Debt Deflation

 1- Mismanagement of financial liberalization/innovation

Financial liberalization and innovation involve the elimination of earlier or existing

 2- Asset price boom and bust

 3- Spikes in interest rates

Caused by failures of major financial institutions, stock market crashes or start of a

Stage two: Banking Crisis

• Sharp or substantial unanticipated decline in the price level

• Decline in real net worth (A-L) of borrowers (firms)

• Lending activity declines

• Economic activity declines

-Unemployment rate reached 25 percent due to the prolonged economic contraction.

In the years preceding the great depression (from 1921-1929):

 Real incomes, money supply and industrial production rose steadily.

-Many investors start to go bankrupt.

-Banks may suffer from bad debts and shortage of liquidity.

-Both demand for and supply of new loans subside.

Source: Dow-Jones Industrial Average (DJIA). Global Financial Data;

Source: Federal Reserve Bank of St. Louis FRED database;

1- Financial innovations emerge in the mortgage markets

Subprime and Alt-A mortgages

Less-than-creditworthy borrowers found the ability to purchase homes through subprime

Commercial banks and mortgage lenders have responded positively to government’s

• Financial engineering developed new financial products to further enhance and

The creation of a collateralized debt obligation (CDO) involves a corporate entity

2- Housing price bubble forms

• Development of subprime mortgage market fueled also housing demand and

• This resulted in increase household indebtedness as a percentage of disposable

3- Agency problems in mortgage markets arise

• “Originate to distribute” model is subject to principal (investor) agent (mortgage

Traditional ‘Originate to Hold’ Model New ‘Originate to Distribute’ Model

Traditional ‘Originate to Hold’ Model New ‘Originate to Distribute’ Model

4- Information problems surface

5- Credit Default Swap (CDS)

-There is a secondary market in which CDS can be traded.

-With a CDS one can hedge risk or gamble and speculate.

When no default or low probability of default : Positive CDS value

5- Housing price bubble bursts

1- US Residential Housing: Falling housing prices

2- Banks’ balance sheets

4- Global Financial Markets

Crisis spreads globally

5- Failure of Banking Firms

High-profile firms fail

Bear Stearns (March 2008)

September 2008: American International Group (AIG) also experiences a liquidity

Merrill Lynch sold to Bank of America at “fire” sale prices.

The end of credit lead to several bank failures.

Bailout package debated

Payment if credit default event occurs

Bank X: CDS seller Investor Y: CDS buyer

One time payment to the

Payment if credit default event occurs

Bank X: CDS seller Investor Y: CDS buyer

Credit default swap

The nominal amount of the CDS contract is the amount of protection. So if an

Both the buyer and the seller:

-May not or usually do not own